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Though bruised, the aerospace and defense industry emerged from the economic downturn in better shape than many industries, due largely to continued demand in the defense sector, as well as some vigilant cost-cutting overall. However, according to the AlixPartners 2011 Global Aerospace and Defense Outlook, both the commercial-aviation and defense industries face critical challenges that must be addressed. The industry now faces the ‘big squeeze’—the contradictory challenges of quickly ramping up production for expected growth in the commercial sector and of needing to address expected cuts in nations’ defense budgets. The combined effect of these demands could lead to severe supply-chain pressures. These pressures, combined with the recent volatility of oil prices and the continued sluggish economies in the West, have made it hard to predict future industry trends.
This uncertainty is leading many aerospace and defense manufacturers, especially lower-tier suppliers, to delay investments, according to the study. Overall, the aerospace and defense industry faces a very challenging next few years. The simultaneous necessity of near flawless execution on the commercial side and belt-tightening on the defense side, plus the need to deal with supply-chain challenges across the board while also seizing M&A opportunities, may push management capabilities to the extreme.
THE RETURN OF GROWTH
After very weak growth in 2009, the overall aerospace and defense industry grew in 2010 by 8.4%. However, this overall growth rate still remains half of the industry’s pre-economic crisis growth rate and varies greatly between Original Equipment Manufacturers (OEMs) and suppliers (figure 1).
As they did before the crisis, suppliers are outperforming OEMs, achieving growth rates as much as 300% higher. OEMs, which have been more resilient during the financial crisis, now lag behind suppliers, and their growth rate is declining. However, there is reason to expect OEM growth rates to turn upward in 2011 and 2012. Overall profitability in the industry was up in 2010 and earnings-before-income-taxes (EBIT) margins experienced their first year-over-year growth since 2007, due to still strong defense segment performance and solid deliveries in commercial aircraft. Moreover, the findings show that in 2010 European companies’ profitability, which historically lagged those of North America, now trails North American companies by just 1.0% (figure 2).
IN THE COMMERCIAL SECTOR
According to the study, the near-term outlook for commercial aircraft is positive, due largely to increasing air-traffic demand globally, which is expected to grow 5.5% by 2012 alone. The need for more-efficient aircraft amid rising fuel prices is already causing heightened demand for new aircraft. This year, for the first year ever, commercial aircraft deliveries globally are set to exceed 1,000 and global aircraft production is expected to increase 30% to 50% over the next three years (figures 3 and 4).
Over the long term, Asia and the Middle East will enjoy 35% of all demand increases. Increasing demand for commercial aircraft, however, does not come without challenges, and the road to meeting global demand may be bumpy. OEMs will be need to ramp up production while simultaneously trying to innovate and develop products to meet demand for more fuel-efficient aircraft. Suppliers —who largely decreased capacity after suffering through the recession—will also face capacity and talent-acquisition constraints as they try to meet demand. Maintaining required levels of design and manufacturing quality will be difficult under these circumstances, par ticularly for smaller suppliers.
There is significant risk that commercial-sector suppliers will not be able to keep up with aggressive new manufacturing demands and will face several challenges, including: capacity constraints of their own suppliers (Tier-2 and Tier-3) that have under-invested in capability development; specialty raw-materials shor tages (e.g., carbon fiber, titanium fasteners, rare ear thelements); and ongoing supply-chain delays and shortages resulting from the disaster in Japan. The aerospace supply chain was severely impacted by the economic downturn, as even sold orders were put on hold or otherwise put in a lumpy, stop-and-go mode. It appears that, as a result, the supply chain may not be fully prepared for the steep commercial rampup curve that lies ahead, and production constraints are a very real possibility.
IN THE DEFENSE SECTOR
But while demand on the commercial-aircraft side looks strong, defense, globally, looks to be weakening. According to the study, U.S. defense spending is expected to decrease by at least 12.2% by 2013 and 6.5% by 2016. These figures may be significantly increased by the deficit reduction deal recently enacted in the U.S. Defense spending in Europe, already down 2.8% in 2010, is expected to continue to drop sharply in the coming years, led by the U.K.’s recent announcement of an 8% cut by 2015 and promised drops of up to 25% in smaller European nations (figure 5).
As a result of these expected widespread cuts, the study indicates that defense priorities will shift toward extending the life of existing equipment, improving communication networks and investing more in weapons systems targeted at supporting today’s more asymmetric warfare. However, it appears unlikely that the scale of these new investments will be enough to make up for cutbacks in major-platform investments such as the F-35 fighter aircraft built jointly by Lockheed Martin Corp., BAE Systems PLC and Northrop Grumman Corp, and the Littoral Combat Ship fleet being built by competing teams led by Lockheed Martin and General Dynamics. These programs have already experienced costly delays and remain targets of budget-cutters in the larger defense companies may need to pursue a more diverse business mix that may lead to partnerships, M&A, and consolidation among smaller players as larger companies pursue new markets.
BUSINESS JETS AND MRO
The global business-jet sector, which suffered a 38% decline in deliveries between 2008 and 2010, may see some degree of recovery but will most likely not experience a significant upturn before mid-2012. Recovery in business jets is expected to be limited largely by the slowly improving global economy. Demand for new aircraft may also continue to suffer from the large pre-owned aircraft inventory overhang (about 14% of the total market) and a lingering negative public perception and media scrutiny over the use of private jets in a time when unemployment remains high and layoffs continue.
After two years of lost growth, the maintenance, repair and operations (MRO ) market is expected to recover by the end of 2012 with 3.7% annual growth, leading to an expected global value of $61 billion by 2020. Fuelled by the engine, components and modifications segments, we expect MRO growth to be driven by demand in developing and emerging markets. We expect North America and Europe, on the other hand, to experience slower growth of 0.7% to 1.6% CAGR, respectively.
THE M&A HORIZON
Given the supply-chain pressures in the commercial sector and budget cuts in the defense sector, we expect the pace of mergers and acquisitions in the aerospace industry to rebound in the next few years (figure 6). Additionally, low valuations today across the industry, with multiples generally below 10 times earnings before depreciation and taxes, have made deals look far more palatable.
On the defense side, the study suggests that smaller companies will be in play as larger players look to encroach on new markets and make strategic, “bolt-on” acquisitions. The larger companies will be looking at these smaller par ticipants that have new technologies, new products, or complementary systems that can be easily and profitably integrated. Across the industry, valuation multiples are down 45% since 2008—and that could well create a ripe deal environment.
CONCLUSION
To improve competitiveness, management will need to focus on disciplined program management, design-to-cost and manufacturability approaches, and risk-sharing supplier management adjustments. Companies will need to move away from the traditional “stick” cost-reduction approach to dealing with suppliers and toward a collaborative approach that optimizes costs along the entire value chain, fully leveraging supplier innovation and cost reduction support. This will require a change of mindset at both OEMs and suppliers, both in terms of collaborative transparency and risk sharing.
Achieving sustained profitability through greater efficiencies and greater innovation remains the name of the game in aerospace, and it’s a game OEMs, suppliers and owners, including private-equity firms, will all have a key role in going forward. As the economy recovers, a clear innovation strategy will also be a differentiating factor both for OEMs and suppliers. The capacity to focus research and development efforts on the right technologies, nurture them and embed them quickly in new programs without increasing risks will be essential in the future. To successfully navigate the paradoxical challenges ahead, the aerospace industry will have to change in ways it has never changed before.